Banking sector health affects ECB’s monetary policy transmission

“[…] it is nonetheless useful to recall again the limits of monetary policy. Monetary policy transmission may be hampered at times where banks, in particular, but also non-financial sectors need to repair their balance sheets. At times of uncertainty and lack of confidence liquidity may be hoarded rather than be put to use for investment. These are cases where standard monetary policy may be “pushing on a string” (in the words of John Maynard Keynes). These are also impediments that need to be fundamentally addressed by regulators and government entities, via the strengthening of financial balance sheets […]” (Yves Mersch, Member of the Executive Board of the ECB, May 2013)

Recent research supports the statement by the ECB. Viral Acharya (NYU), Bjoern Imbierowicz (CBS), Sascha Steffen (ESMT) and Daniel Teichmann (Goethe) investigate the transmission of monetary policy around what you can call a game changing moment in ECB monetary policy, the introduction of the full allotment, in which banks can get unlimited amount of central bank funding at the prevailing ECB interest rate in exchange for collateral. This was the first time that the ECB acted as so-called “Lender of Last Resort (LOLR)” responding to a break-down of the interbank market, which left some banks with insufficient liquidity.

These are the key results:

• In this paper, we marshal a lot of evidence that shows that banking sector weakness impairs the transmission of monetary policy.
• Using deposit and loan transaction data from the same banks, we investigate the impact of central bank liquidity on bank deposit and corporate loan spreads for the June 2006 to June 2010 period. While higher central bank liquidity decreases deposit spreads of low-risk banks, it does not have an impact on the deposit spreads of high-risk banks at the start of the financial crisis. Loan spreads are also not affected by changes in central bank liquidity.
• After the ECB began to fully allot all liquidity requested by banks via the refinancing operations in October 2008, we find that an increase in central bank liquidity results in the same decrease of deposit spreads for low- and high-risk banks.
• However, we still document differences in the transmission via loan markets for high-risk banks versus low-risk banks. We find that more central bank liquidity implies a reduction of loan spreads charged by low-risk banks but has almost no effect on the loan spreads of high-risk banks.
• We also show that borrowers of high-risk banks refinance expiring term loans with loan commitments. They decrease (increase) the percentage of term loans (commitments) in their capital structure and experience negative real effects in the years after having received a loan from a high-risk bank.

These are the policy implications:

1. Our results offer the interpretation that the previous programs (such as the Long-Term Refinancing Operations (LTRO) or Securities Market Program (SMP)) that were supposed to increase lending and growth across the euro area after the sovereign debt crisis might not have been successful. Europe was struggling with a weak banking system and regulators and governments have not decisively dealt with this weakness. Moreover, a series of stress tests in Europe since March 2010 did not help to strengthen the banking system and regulators did not ask banks to raise much capital.
2. Our results cast doubt on the effectiveness of the newly initiated quantitative easing (QE) program by the ECB in March 2015. The ECB is supposed to purchase sovereign debt and other fixed income instruments for more than EUR 1 trillion until end of 2016. Before the start of QE the ECB conducted a comprehensive assessment. This assessment involved an Asset Quality Review (AQR) to identify problem assets in Europe’s largest 130 banks using a common evaluation scheme and a stress test to test the resilience to shocks over a 3-year period. Overall, these tests resulted in about €20 billion in capital shortfalls across all tested banks and might not have ultimately improved the health of European banks.
3. The actions of the ECB to support the euro area economy through various programs provide support to a troubled financial system, thereby making it possible for the ECB and national regulators to delay dealing with troubled banks. It is effectively providing assistance to banks that likely have solvency problems. This facilitates forbearance because national regulators may have even more incentives to defer actions as the problems are partly addressed by the ECB’s policy. Some banks thus might become fully dependent on ECB liquidity.
4. Differences in banks’ creditworthiness across the Eurozone suggests that there are possible distributional consequences of ECB liquidity provision. Countries with a rather healthy banking system benefit from extraordinary liquidity provision while countries with weak banks do not benefit or even suffer. The situation might actually get worse because of moral hazard and risk shifting incentives of under-capitalized banks.

Source:
"Does Lack of Financial Stability Impair the Transmission of Monetary Policy?" with  V. Acharya, B. Imbierowicz, and D. Teichmann, October 2015